March 1, 2022
While the facts on the ground with respect to the Russian invasion of Ukraine are constantly changing, I wanted to share a few thoughts about the implications of the unfolding crisis. Putin has now mobilized 120,000 active Russian troops and shows no signs of backing down. There is little evidence so far to suggest that peace talks are going to make a sizable difference, and the risk of further escalation remains significant. Putin also may be less mentally sound than in the past, and has shown worrying physical signs in recent speeches.
Now that he has been hit by Iran-level sanctions and has united NATO to a degree not seen in decades, he is unlikely to feel incentivized to back down. Yet, his offensive actions have backfired in surprising ways. Even the Swiss have taken a respite from their usual neutral stance to freeze Russian assets. The French and German governments are demonstrating a renewed interest in common defense and are actively pushing back against Putin’s aggression. Berlin has acknowledged that trusting Russia in the natural gas sphere was a strategic error and halted the Nord Stream 2 pipeline project.
The current wave of sanctions is estimated to wipe out as much as 5-10% of Russia’s GDP. High oil prices may continue to aid Moscow in its time of need, but its petroleum is already trading at a 10% discount to comparable crude. While it may take several painful years for countries like Germany and Italy to wean themselves off Russian gas dependency, and Russia’s economy is somewhat insulated from outside pressures, the psychological impact of its growing isolation should not be minimized. China is a wild card in all of this, and for the moment it is unclear to what extent they may wish to throw a life line to the Russians.
While the Russian economy is less than 3% of world GDP, its potential impact on the global economy in general, and on Europe in particular, should not under estimated. Even though Russia is a major oil producer, it only provides about 5% of total global oil supply. However, it does furnish close to 20% of Italy’s total energy consumption, and about 17% of Germany’s. While it may be tempted to retaliate against Western sanctions by cutting back on energy exports, the fact that the West has effectively frozen roughly 60% of the country’s $600 billion in foreign currency reserves will limit Russia’s room to maneuver.
Another way Russia may seek to retaliate against sanctions is by defaulting on its debt. Fortunately, the scale of that debt is relatively small. As result, even in the event of a default the impact will be quite small. France and Italy have the biggest exposure (roughly $25 billion each) to Russian debt, but no individual bank appears to be significantly threatened.
Perhaps more worrying is that Russia is the world’s largest exporter of wheat, supplying over 20% of global demand, and that Ukraine is the 5th largest. Russia also generates over 40% of the world’s palladium, which is an essential ingredient for catalytic converters. At the very least the current situation is likely to further disrupt global supply chains and contribute to inflation.
This puts the FED in an extremely tricky situation because normally it would be loosening the purse strings to reassure markets in light of the tense political situation. However, given current high inflation rates, its options are limited. A March increase in interest rates is probably still in the cards, but it will likely only be by 25 basis points, and we may not see the 6 or 7 increases during the remainder of the year that many analysts were predicting.
Longer term, the economic implications are for more economic decoupling between the West and East, which will surely have a negative impact, as globalization slows, and global trade flows are diminished. More defense spending and lower consumer demand are likely to follow, with global GDP growth rates falling by as much as 1%. However, the global impact will by no means be homogeneous, and will vary by region. Europe is likely to bear the brunt of the disruption, while other oil exporters are already benefitting from higher oil prices. In contrast, Japan, with its high degree of dependence on energy, will suffer, while the US is likely to remain relatively unscathed. On a positive note, alternative energy plays should gain substantially as the world seeks to free itself from fossil fuels and the political leverage they provide to some unsavory characters.
More importantly, in terms of our asset allocation and portfolio construction I think Polygon is in a pretty good place. Our defensive orientation, with a relatively low allocations to stocks, coupled with our geographically diversified global strategy, is standing us in good stead. A healthy allocation to cash, and, importantly, to alternatives, is providing stability to our portfolios, with the gold and commodities positions proving particularly helpful. For the moment, we intend to maintain our risk averse approach, and perhaps even slightly increase our weighting in lower risk securities.
B Philip Winder